Fair Return

FAIR RETURN PETITIONS

Have the courts identified a single method for calculating a fair return? Yes/No/Maybe

The correct answer is No. The fair return issue has become the most complex issue in the drafting and administration of rent stabilization ordinances. Every ordinance must provide park owners with the opportunity to petition for rent adjustments based on claims that they are not getting a "fair return.” While the courts have mandated that owners subject to rent controls are entitled to a fair return, there is no judicial consensus as to what that constitutes, or as to the proper methodology to be used in calculating fair return. In fact, appellate court conclusions on fair return issues contradict each other, leaving ordinance drafters with no definitive legal direction.

FAIR RETURN METHODS

Is maintenance of net operating income one method for determining a fair return? Yes/No/Maybe

The correct answer is Yes. Traditionally, the methodologies used under rent controls have included return on value, cash flow, return on investment, percentage of net operating income, or maintenance of net operating income (1).  In administering fair return standards which have not mandated the use of a particular formula, some jurisdictions have used return on historic investment or internal rate of return approaches.

JUDICIAL PRECEDENTS

Have the courts concluded that park owners are entitled to a fair return on the value of their property? Yes/No/Maybe

The correct answer is No. The judicial precedents which address what constitutes a fair return leave basic issues unresolved and in some cases pronouncements in court opinions actually compound rather than resolve uncertainty.

But the courts have clearly and unequivocally concluded that park owners are not entitled to a fair return on the "value" of their property on the basis that such an approach is "circular.” Circularity results from the fact that value is determined by rents and, therefore, cannot be used as the yardstick to determine what rents should be permitted.

The State Supreme Court has also concluded that no particular type of fair return formula is required, (2) and that ordinances are not required to have a specific formula.

REFERENCES

1. For discussion of fair return issues see Baar, Guidelines for Drafting Rent Control Laws: Lessons of a Decade (1983) 35 Rutgers L. Rev. 721, Chapter VII.
2. Fisher v. City of Berkeley, supra.

Source: The GSMOL Mobilehome Rent Stabilization Ordinance Handbook, Second Edition: Guidelines for Drafting and Enacting a Mobilehome Rent Stabilization Ordinance.

Prepared by: Bruce Stanton, Esq., Corporate Counsel

Image courtesy of Stuart Miles at freedigitalphotos.net

Return on Investment Standards

OPTIONS

Ordinances usually contain either (1) a fairly specific maintenance of net operating income (NOI) formula, or (2) a statement that a park owner is entitled to a fair return on investment without a definition of those terms, or (3) a list of factors that must be considered, without stating how they shall be weighed (i.e. the Escondido Ordinance model).

It is common for ordinances and court decisions to also include language to the effect that a fair return on "investment" must be permitted – again, without a definition of those terms.

PRACTICAL PROBLEMS

As a practical matter, there are serious problems associated with return on investment standards. The process of determining investment and return can be troubling. For example, a property may be inherited, or there may have been refinancing, which make investment difficult to determine. Or there may be two investors in the property (the landowner and a park owner with a long-term land lease). Furthermore, rates of return on investment vary substantially among properties depending on their purchase dates and financing arrangements. There is no single rate or range of rates of return on investments that are considered typical for real estate investments.

A long-term owner may be charging low rents, yet may be earning a high rate of return.  Conversely, a recent purchaser may be charging high rents, yet may be earning a low rate of return on investment.  In the 1970’s and 1980’s real estate investments typically had negative cash flows in the first years after a new purchase, as prices reflected substantial anticipated growth in income, value and tax shelter benefits as well as current income.

MEASURING INVESTMENT AND RETURN

The result of the foregoing is that when an ordinance requires a fair return on investment, it cannot contain specific definitions of investment or return. Instead, rent boards struggle to determine how to measure the investment and return. Some boards apply widely differing standards or make decisions on a case-by-case basis without any standards.

Source: The GSMOL Mobilehome Rent Stabilization Ordinance Handbook, Second Edition: Guidelines for Drafting and Enacting a Mobilehome Rent Stabilization Ordinance

Prepared by: Bruce Stanton, Esq., Corporate Counsel

Image courtesy of imagerymajestic at freedigitalphotos.net

Maintenance of Net Operating Income

DEFINITION

This Author strongly recommends that a maintenance of net operating income (M-NOI) approach be used. (Net operating income = gross income - net operating expenses).(1)

Under the M-NOI approach, the park owner’s pre-rent control net operating income is maintained, with some adjustment for inflation.  For example, a fair net operating income may be defined as base year net operating income adjusted by 50% of the rate of increase in the Consumer Price Index.  Thus, if the base year net operating income of a property was $100,000.00 and the CPI has increased by 30% since the base year, a fair net operating income would be calculated at $115,000.00.

ADVANTAGES

The advantage of this formula is that it is consistent with the basic purpose of rent controls:  to allow rent increases which are adequate to cover operating cost increases, without permitting excessive increases. This approach is simple in comparison to other fair return approaches, because it does not require complicated determinations of investment, adequate rate of return, and/or value. Instead of undertaking the very subjective task of determining what rates of return might be fair, it presumes that the pre-regulation level of net operating income was fair and preserves that profit level. Also, this approach is not subject to manipulation through purchase and sales of parks and changes in financing arrangements (2).

PERMITTED AND EXCLUDED EXPENSES

Net operating income standards in ordinances should contain a list of permitted and excluded expenses. 

Debt service, which is the mortgage interest expense incurred by the park owner, is excluded. This exclusion is an inherent and vital part of the net operating income approach, since net operating income is defined as income before debt service.

Ground lease expenses are commonly, but not universally, excluded. Some ordinances only allow "involuntary" increases in ground lease expenses which result from arrangements entered into before the adoption of the rent control ordinance. Courts have upheld the exclusion of ground lease expenses, on the ground that lease payments are an investment expense rather than an operating expense.

LEGAL REVIEW

The M-NOI approach is used by at least twenty (20) California jurisdictions.  While courts continually reiterate that rent boards do not have to use a particular type of fair return standard, they commonly use trends in net operating income as the benchmark in evaluating whether a fair return has been permitted (3). In Rainbow v. City of Escondido (1998) 64 Cal. App. 4^th 1159, 1172, the Court of Appeal held that the MNOI standard is a “fairly constructed formula” and upheld its use.

REFERENCES

1. Detailed justification for a net operating income approach is set forth in Baar, Guidelines for Drafting Rent Control Laws: Lessons of a Decade, 35 Rutgers L.Rev. 721, pp. 809-816.

2. Fisher v. City of Berkeley, supra; Helmsley v. Borough of Fort Lee, supra; Mayes v. Jackson TD, Rent Leveling Bd (N.J. 1986) 511 A.2d 589.

3. A number of appellate court opinions in rent control cases have concluded that permissible rent levels should not vary depending on the particular financing arrangements of the property owner.  See Helmsley v, Borough of Fort Lee (N.J. Supreme  Court 1978) 394 A.2d 65; Palomar Mobilehome Park Assn. v. Mobilehome Rent Review Commission (1993) 16 Cal.App.4th 481 [___ Cal.Rptr.2d ___].

Source: The GSMOL Mobilehome Rent Stabilization Ordinance Handbook, Second Edition: Guidelines for Drafting and Enacting a Mobilehome Rent Stabilization Ordinance

Prepared by: Bruce Stanton, Esq., Corporate Counsel

Image courtesy of Ambro at freedigitalphotos.net

Savings Clause

DEFINITION

While the Courts have consistently indicated that a local jurisdiction can select its fair return standard, they have also permitted property owners to use other formulas in fair return hearings.  A “savings clause” is a provision which authorizes a board, commission or hearing officer to consider any information on fair return that may be relevant, as well as the information that the jurisdiction requires under its particular formula.

COURT REVIEW

Rent Stabilization Ordinances commonly contain maintenance of net operating income (M-NOI) standards without providing authority for a board to consider other standards. In one decision, involving Oceanside mobilehome space rent controls, a Court of Appeal ruled that the Rent Commission must consider whatever fair return evidence the park owner chooses to present (1).

In the event that a board fails to consider all the alternatives that the owner elects to present, a fair return hearing may be conducted by the court. When this occurs, the costs may be extremely high, far higher than the cost of a hearing held by a board or hearing officer.

MIXED RESULTS

Experts polled were not unanimous over whether a "savings" clause should be included. On the one hand, such a clause may protect the city from judicial intervention in the administration and interpretation of fair return issues. On the other hand, a savings clause opens up each administrative hearing to the possibility of becoming a long and open-ended process, based on consideration of highly subjective factors. Furthermore, while other types of fair return formulas may lead to reasonable results in some cases, they do not consistently lead to logical results.

When a savings clause is used, it is recommended that the M-NOI ordinance also contain a requirement that a  analysis must be performed, as well as any other types of analysis that are required in order to respond to a park owner's fair return claims.

REFERENCES

1. Merrill L. Kirkpatrick v. City of Oceanside (June 1993) San Diego County Superior Court No. 655132.

Source: The GSMOL Mobilehome Rent Stabilization Ordinance Handbook, Second Edition: Guidelines for Drafting and Enacting a Mobilehome Rent Stabilization Ordinance.

Prepared by: Bruce Stanton, Esq., Corporate Counsel

Image courtesy of Stuart Miles at freedigitalphotos.net

Indexing Net Operating Income

CALCULATION OF FAIR RETURN

Have the courts approved indexing of net operating income adjustment? Yes/No/Maybe

The correct answer is Yes. Ordinances which contain maintenance of net operating income (M-NOI) standards typically define fair return as a base year net operating income adjusted by a portion of the percentage increase in the Consumer Price Index since the base period, rather than the full increase in the CPI. The courts have not taken a definitive stand on what would be the minimally acceptable rate, but have approved indexing in various amounts.

INDEX RATE

Can net operating income adjustments be pegged at 40% of the CPI? Yes/No/Maybe

The correct answer is Maybe. Most ordinances with M-NOI standards define fair return as base period NOI adjusted by approximately two-thirds of the rate of increase in the CPI. Some index at 40% of the rate of increase in the CPI. 

Note that this CPI adjustment is separate from and, if authorized, in addition to that described in the Annual Across-the-Board Rent Increases post.

Source: The GSMOL Mobilehome Rent Stabilization Ordinance Handbook, Second Edition: Guidelines for Drafting and Enacting a Mobilehome Rent Stabilization Ordinance.

Prepared by: Bruce Stanton, Esq., Corporate Counsel

Image courtesy of Stuart Miles at freedigitalphotos.net

Capital Improvements

INTRODUCTION

Should park owners be reimbursed for capital improvements?

GSMOL does not favor a provision which would allow the park owner to receive reimbursement for capital improvements dollar-for-dollar that is separate from NOI adjustments to base rent.  Such provisions are constitutional and some ordinances contain them. 

Standards for capital improvement increases vary substantially among ordinances, depending on what types of incentives are intended and for what types of improvements they are intended.  The following discussion describes some of the issues associated with these standards.




CONSIDERED SEPARATELY OR WITH A FAIR RETURN ANALYSIS

Are Capital Improvements considered independently or only in conjunction with a Fair Return Analysis?

An ordinance may authorize rent increases for capital improvements regardless of a park owner’s profit level.  This approach ensures that there are extra incentives for capital improvements regardless of the owner’s profit level.  At the same time, such an approach may encourage an attempt to divert ordinary expenses into capital improvement categories, where the hearing would not require an examination of the park’s entire income or expenses.

If capital improvements are considered in conjunction with overall profit levels, then the definition of capital improvements becomes less critical since all expenses will be considered regardless of how they are classified (unless certain types of expenses are expressly disallowed).

Source: The GSMOL Mobilehome Rent Stabilization Ordinance Handbook, Second Edition: Guidelines for Drafting and Enacting a Mobilehome Rent Stabilization Ordinance.

Prepared by: Bruce Stanton, Esq., Corporate Counsel

Capital Improvement Defined

WHAT IS A CAPITAL IMPROVEMENT?  

Some ordinances define capital improvements as both a replacement of an existing thing or a new improvement, while others only permit increases for new improvements. Other ordinances only permit increases for new elective (i.e. not necessary) improvements if they are approved by a majority vote of the park residents.

INTERNAL REVENUE CODE

The ordinance language should define what is meant by a capital improvement. The Internal Revenue Code can be used as a guide for distinguishing between a capital improvement and an ordinary repair. 


ORDINARY REPAIRS

Ordinary repairs should not be considered a pass-through. Pursuant to section 162 of the Internal Revenue Code, expenditures for ordinary and necessary repairs to business property can be deducted in the year paid. Where an expense is deductible, it should not be considered a capital improvement.

According to IRS Publication 527, a repair is something that keeps the property in good condition, and does not materially add to the value of the property or prolong its useful life. Examples are fixing gutters, repairing roof leaks or floors or replacing broken windows. These types of items should never be considered capital improvements.

IMPROVEMENTS

Improvements are defined by the IRS as work which adds to the value of property or prolongs its useful life. Examples are putting on a new clubhouse roof or room, or erecting a fence.

SIZE OF THE EXPENDITURE

The smaller the expenditure, the more likely that it will not be a capital improvement. Generally, the IRS defines any expense under $100.00 as a deductible expense.

INCENTIVES

An ordinance may give greater incentives for particular types of improvements through such variables as higher interest rates or shorter amortization periods for those improvements.

Source: The GSMOL Mobilehome Rent Stabilization Ordinance Handbook, Second Edition: Guidelines for Drafting and Enacting a Mobilehome Rent Stabilization Ordinance.

Prepared by: Bruce Stanton, Esq., Corporate Counsel

Image courtesy of Arvind Balaraman at freedigitalphotos.net

Fees

ATTORNEY'S FEES AND COSTS

Many ordinances provided that all legal or accounting fees incurred by the park owner in connection with rent increase proceedings be excluded from the list of operating expenses allowed under MNOI.  The case of Galland v. City of Clovis(2001) 24 Cal. 4^th 1003, may now require that such fees be included as allowed operating expenses.

LOCAL GOVERNMENT FEE

Many ordinances authorize the jurisdiction to charge fees for each mobilehome space in order to help defray the costs to the city of administering the law. Commonly, the park owner is required to pay the fees on an annual basis, but may pass through all or part of the fee to the residents.

OPPOSE OR SUPPORT GOVERNMENT FEES

Homeowners may feel a natural inclination to oppose these fees. But many residents also recognize that payment of a small annual registration fee is beneficial, since the money is used by the City to support the administration of a policy that is in the homeowners' interest. These homeowners see the cost of such a fee as small when compared to the benefits deriving from a rent ordinance.  A jurisdiction may not be willing to pass an ordinance without such a fee structure.

NO FEES FOR SPACES EXEMPT FROM RENT CONTROLS

In 1993, state law was amended to prohibit the assessment of fees on park spaces that are exempt from rent controls due to the presence of long-term leases.

Source: The GSMOL Mobilehome Rent Stabilization Ordinance Handbook, Second Edition: Guidelines for Drafting and Enacting a Mobilehome Rent Stabilization Ordinance.

Prepared by: Bruce Stanton, Esq., Corporate Counsel

Image courtesy of Marcolm at freedigitalphotos.net